How to Read a Balance Sheet

Matt Quinn contributes to the Wall Street Journal's corporate finance blog. He has also written extensively about banking and corporate finance for publications including Inc., American Banker, and Financial Week. He lives in Brooklyn, New York.

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Even though the income statement normally attracts the most attention from investors, the balance sheet is the true starting point for understanding a company's financial position. It shows how much a business owns (its assets), owes (liabilities), and how much equity is leftover for the owners at a specific point in time. (For more detail, read this primer on the basic elements of a balance sheet.)

To get a feel for how a pro dives into a balance sheet, Inc.com spoke with Tom Robinson, managing director of the education division of the CFA Institute in Charlottesville, Virginia. The institute created the Chartered Financial Analyst designation held by many stock analysts and portfolio managers.

Reading a Balance Sheet: Liquidity and Solvency

When looking at a balance sheet, two of the most important things you want to get a feel for are a company's liquidity and solvency, says Robinson. Liquidity is a company's ability to meet its short-term obligations, such as its working capital needs and its debt obligations. Solvency is a measure of the company's ability to sustain its activities over a longer period of time.

When assessing a company's liquidity, one key ratio is a company's current assets in relation to its current liabilities, or what is known as the current ratio. Current assets include cash, cash equivalents, securities, accounts receivable, inventory, and any other assets that can be converted into cash or used up within the current period. Current liabilities are what a company needs to pay off over the coming year. A good ratio is going to vary from industry to industry, but, in general, a bank would like to see a current ratio of 2 to 1 for a small business, Robinson says. That is, the company should have twice as many current assets as liabilities. The strength of the ratio as a measure of liquidity will also vary greatly by industry; a shipbuilder's inventory will be a lot less liquid than that of grocery store, Robinson notes.

Because inventory can be a lot more difficult to turn into cash, analysts use another ratio, known as the quick ratio, to measure liquidity. Typically the quick ratio excludes inventory from the numerator, leaving just cash, marketable securities, and receivables to be divided by current liabilities. These are considered the assets most easily turned into cash. However, it should be noted that some companies, those in retail for example, can probably convert their inventory into cash more quickly than others can collect their receivables.

Next up is solvency. Here, an analyst wants to look at the level of total debt relative to the equity used to capitalize a business by its owners. 'You want to see some balance,' says Robinson. 'And that balance is going to vary a lot from industry to industry.' For example, banks do much of their financing with debt, whereas a service company, like an accounting firm, is likely financed mostly with equity.

In reviewing a balance sheet, you want to think next about what would happen if you were forced to liquidate an asset. By doing so, you'll need to look at whether a company's assets are tangible or intangible. Tangible assets are physical in nature and include cash, inventory, buildings, equipment and accounts receivable.

Intangible assets are items like patents and trademarks. These assets often have real value, but you need to carefully examine them to ascertain it. If a company has made many acquisitions, for example, it could have a considerable amount of goodwill listed as an asset, or the amount it paid for a company in excess of the fair value of its net assets. This would be considered an intangible asset, because 'if things get bad, I can't cash in that goodwill,' Robinson says. Furthermore, there's alawys the chance that if the deal doesn't pan out as expected, the company will have to write down the goodwill.

Another spot on the balance sheet to reviewwith a healthy dose of skepticism is other comprehensive income, which is included in shareholders' equity. This figure reflects income and losses that have been left off the company's income statement. Foreign currency translations are kept here, for example. Suppose a company is earning revenue in yen, but never actually exchanges that yen for dollars. Any unrealized foreign currency gains or losses will be listed under other comprehensive income. In general, it's a line item chockfull of money that may never be realized and won't count for much in the event of a liquidation.

As with an income statement, one of the best ways to get a feel for a balance sheet is to break it down into percentages, or to perform a common-size analysis. For an income statement, the best way to do such an analysis is to take all the items on the statement and divide them by revenues. With a balance sheet, there are two ways to perform this analysis.

First, you may conduct a vertical common-size analysis, where, similar to the income statement analysis, you express assets, liabilities, and equity as a percentage of total assets. You want to look at these percentages over a period of about three years to spot changes. If inventory was 10 percent of total assets last year and 12 percent of total assets this year, you now know that inventory grew faster than total assets. You can then investigate why that is so.

Second, you may perform a horizontal common-size analysis. Here, you want to calculate the year-over-year change for each line item of both the balance sheet and the income statement. What you're looking for is how an item has changed relative to how total assets and revenue have changed. From this, you may be able to see that while revenue grew at a 10 percent clip and assets increased by 5 percent, inventory surged by 15 percent. A careful reader would then wonder why the company is building up inventory when revenue is increasing at a strong pace. 'It might be a sign there is poor earnings quality or maybe they're overstating inventory or building it up too much,' Robinson says. Either way, the balance sheet is warning you that there is some sort of inefficiency with which you should grapple.

Another area to look at closely is receivables. If they're increasing faster than revenue, that may be a signal that the company has a problem with collections. In this case, you may worry that the company isn't increasing its allowance for doubtful accounts at a fast enough pace.

The balance sheet can give you a view not just into earnings quality, but how well the company is managing its inventory and receivables. A few important ratios to keep in mind:

Inventory turnover = cost of goods sold divided by average inventories

Receivables turnover = sales divided by average accounts receivable

Total asset turnover = sales divided by average total assets

You'll want to look at how these ratios change over time, as well as how the company is performing relative to its peers. (Sageworks, Dun & Bradstreet, and the Risk Management Association are a few sources for financial information on small and midsize businesses.)

When reading a balance sheet, financial laymen are most often tripped up when revenue or expenses occur at a different time than the cash is received or paid, Robinson says. When this happens, a company faces a deferred asset or liability.

For example, what you pay the IRS in taxes will often differ from the amount of income tax expense you calculate for financial reporting purposes. If the amount you pay the IRS is more than your tax expense on your income statement, you record a deferred tax asset on your company's balance sheet. If it's less, you record a liability, because you will have to pay more out at a later date.

These aren't warning signs as much as timing issues. In fact, a liability could actually be a good thing. In the case of an airline, you typically pay the airline before it delivers any service to you. Until that service has been delivered, the airline will actually record a liability on its balance sheet because it is something it owes.

"If they've deferred revenues or even deferred tax liabilities, that's not a bad thing," says Robinson. "It means they collected revenue in advance or postponed the payment of taxes by selecting their tax accounting method appropriately."

Reading a Balance Sheet: Final Thoughts

Though a balance sheet is intended to be a gateway to understanding a company's financial position, there are many nooks on one for valuable information to hide. Make sure you update your company's balance sheet on a regular basis, encourage your management team to pore over it for useful information, and review the balance sheets of businesses in which you invest or with which your company forges a strong business partnership. The numbers listed on a balance sheet provide you with data that can help you make smarter decisions. These numbers will also give you a head's up when trouble is brewing. Don't be intimidated. Use the tool to make informed management decisions.